Wednesday, September 30, 2009

Looks like we're going to have to settle for a double play on oil instead of the originally intended triple play. I rather inconveniently deleted Options Action off of my DVR and seem to have lost my sticky note that held the second trade's details. Although I remember it was a naked put sell plus a bear call spread, I don't recall which strikes were used.

Ah well....

How bout that IVolatility play on the USO? From a fundamental standpoint IVol asserted that due to seasonal factors, crude usually peaks around this time of year. From a technical view, USO recently broke it's up trend line on higher volume. So both forms of analysis allude to more bearishness to come.

This is a straightforward call spread where we're betting USO remains below $35.

Put Ratio Backspread:

Sell Nov 34 Put for $2.45

Buy (2) Nov 31 Puts for $2.40

Net Credit = $.05

Since most readers are probably familiar with the risk graph of a call spread, I'll simply display the risk graph of the backspread-

[Source: EduTrader]

Whereas the call spread merely needs USO to remain below 35 by Oct expiration, this backspread profits if USO drops significantly before Nov expiration. While the call spread is a less aggressive, higher probability bearish bet; the backspread is a more aggressive, lower probability bet. Although IVol suggested doing both, you could obviously choose to enter only one of the strategies if you prefer. In addition to the aggressiveness of both plays, another noteworthy difference is the fact that the ratio backspread is a negative theta trade. As such, I wouldn't recommend holding it all the way to expiration.

Of the plays highlighted, I think I still prefer the Nov 33-31 1x2 put spread mentioned in Monday's post.

I got a couple of questions about the spread between historical volatility and implied vol.

When you study this spread you’re actually seeing different volatility periods right? The implied is for the next 30 days and the historical is from the last 30 days.

Do you make any kind of adjustment to the series or just leave them like that, with different dates.If the implied vol. you're studying is for an option that expires in say 20 days, do you still compare with 30 day HV or do you use the same number of days for the historical volatility as the number of days to expiration?

Thanks a lot!

Decio

***

When I’ve talked about comparing historical volatility to implied volatility in the past, I’ve typically been comparing 30 day HV to IVolatility.com’s IV Index Mean. As the name implies, 30 day HV does look back over the past 30 days so you’re correct in that assumption. As far as the IV Index Mean, I’m almost 100% sure the graph I use looks forward 30 days. Here’s how IVolatility describes their IV Index Mean:

“The Implied Volatility Index is calculated by using a proprietary weighting technique factoring the delta and vega of each option participating in IV Index calculations. In total, we use 4 ATM options within each expiration to solve for the Implied Volatility Index of each stock. This IV Index is normalized to fixed tenors (30, 60, 90, 120, 150, 180 days) using a linear interpolation by the squared root of time."

I believe the IV index they’re using in the graphs I’ve shown is the 30d IV, which shows what volatility is expected to be (based off current option prices) in the ensuing 30 days. Keep in mind you don’t have to use the IV index mean. Remember each option has its own implied volatility, so you could simply use the IV of whatever individual option you’re trading or the average IV of the options trading in that expiration month. Most brokers display that information. Here’s a graphic from Think or Swim showing the IV levels of RIMM options for each expiration month. This picture was taken on Sept. 24th, the day before earnings (click image to enlarge).

[Source: ThinkorSwim]

Notice how the front month (OCT) options were trading at higher vol levels than the later months. This helps show the expectation of higher volatility in the short term (due to the imminent earnings announcement), but lower volatility in the back months. At the time the IV index mean was around 56%- which seems close to an average of the IV of every expiration month.

In tackling the question as to which HV I use, this is where personal preference comes in. The conventional approach (at least the way I was taught) is to use the historical volatility that looks back the same amount of days you’re going to be in the trade. So if I’m entering an option trade for approximately 30 days, then I’ll compare implied volatility to 30d HV. If it’s a 60 day option trade, then I may use 60 day HV instead. It really comes down to which HV reading you think gives the best indication of future volatility. Sometimes I use 10 day HV because it’s more sensitive to recent price action and thus gives a more accurate picture as to how volatile the market is right now. Let’s say you have the following volatility readings on XYZ:

10d HV 50%, 30dHV 30%, 60d HV 35%, IV Index Mean 47%

Which HV reading should we use in comparison to current IV? My answer would be the one that is closest to how volatile the stock will be throughout the duration of your trade.Is there any way to really know that before hand?Well, not really.It’s an imperfect science.Currently 10d HV is much higher than 30 and 60 day HV showing that the stock’s volatility has picked up recently.If you think that increase in volatility will persist going forward, then I’d probably use 10d HV in comparison to IV.If, on the other hand you think the increase in stock volatility is an aberration and it’s likely to revert back closer to 30 or 60 day HV, then I’d use those readings in comparison to current IV levels.In the case of 10d HV vs. IV (50% vs. 47%), it seems like options are right in line.If we compare 30d HV to IV (30% vs. 47%), then options seem a little rich and I’d probably lean toward being a seller.

If you missed my four part series on Historical Volatility you can view them here: Part I, II, III, IV

IVolatility.com also has some great resources within the Knowledge Base or Education part of there website. I'd recommend checking that out if you seek more information on volatility.

ADDENDUM:

It's probably important to add that most data providers use trading days when calculating HV and calendar days when calculating IV. So while 30d IV consists of 30 calendar days, it comes out to approximately 21 trading days. Thanks to Bill Luby for pointing that out. His post The Gap between the VIX and Realized Volatility sheds more insight.

In layman's terms, the USO tracks crude oil. In addition to tackling the two strategies highlighted by our Options Actions pals, I'll also take a look at a third potential strategy mentioned in this week's IVolatility Trading Digest Blog.

The 1x2 put spread, explained in my recent post on Best Buy earnings, can be thought of as a normal bear put spread with an additional naked put. The suggestion was to buy a 33-30 put spread and simultanously sell a 30 strike naked put. To realize our maximum profit on the put spread we need the stock to drop to $30. However, since we're short an additional 30 put option, we can potentially lose money if the stock drops too much. Based on the risk graph below, our profit zone resides between $27.15 and $32.80. Although this is a bearish trade, if USO drops more than 21% (below $27.15), it could turn into a loser. The odds of USO dropping over 21% are very small in my opinion. Furthermore, if it did drops that far I wouldn't mind getting long the stock at those prices anyways.

[Source: EduTrader]

In addition to the downside risk of the USO falling too far, we are also risking the net debit of $.10 if USO remains above $33 at November expiration. This is one of the advantages to this specific strategy- minimal upside risk. Take a look at the risk graph juxtaposed with the price chart (click image to enlarge).

[Source: EduTrader]

Variation Idea: One may consider using the 31 strike instead of 30. Currently the Nov 33-31 put spread is trading around $.30 credit. Although this raises your lower breakeven, it eliminates any upside risk because if USO is above $33 at Nov expiration you keep the $.30 credit. I personally like the risk-reward characteristics of using the 31 strike better.

So the RIMM trade didn't work out as we would have liked. Indeed, RIMM was taken behind the woodshed and beat severely (or at least more severely than expected) for its disappointing earnings. I don't even know what the actual earnings were, nor do I really care. The price reaction should tell us all we need to know. As far as volatility and the strangle play go, despite the vol ramp up into earnings and "apparent" overpricing, turns out the vol wasn't so "overpriced" after all. Rather than bemoan our fate as volatility sellers, let's take a look at what we can learn from our trip to the woodshed. Although today's musings may not assuage your financial pain (assuming you took a short vol play), at minimum it may shed (pun intended) insight on how to properly approach and manage volatility plays.

1. IV-HV analysis is NOT infallible. No matter how high implied volatility is compared to historical volatility, options can still be underpriced. Pre-earnings on RIMM, IV was at 56% while HV was at a mere 26%. The assumption we make when IV is extremely (you be the judge for what determines "extremely") higher than HV, is that options may be overpriced. There's certainly a better chance of them being overpriced when IV is higher than HV vs. being lower than HV in my opinion. However, past is not always prologue! Just because RIMM experienced 26% volatility over the last 30 days doesn't mean it can't experience 100% volatility in the next 30 days. Because options are forward looking and no one knows the future there is always uncertainty in making volatility bets.

Though we weren't making a directional bet with the RIMM strangle, we were making a volatility bet or magnitude of the expected move bet. Although I'll concede that forecasting volatility is usually easier than forecasting direction, it's still not infallible. Unless your deluding yourself, those of you that have been in the game long enough know there is no such thing as a sure thing when forecasting the future. If you haven't been in the game that long or are sitting on the pine thinking about entering the game, well then take my word for it.

2. Don't be stupid when position sizing. I think the plain old phrase don't be stupid PERIOD would have worked, but I wanted to focus on stupidity in the context of position sizing. No matter how confident you are in a trade, don't put in more money than you can afford to lose! I ended up entering the RIMM strangle at around $3.60 credit. I exited for a $5.20 debit resulting in a loss of about $1.60. Had I merely entered 1 lot of strangles, I would be down a mere $160. Had I entered a 10 lot, I would have lost $1600. A 20 lot would have lost about $3200. Remember, you are in almost complete control of risk by controlling the size of your position.

3. Have an exit plan. Check your HOPE at the door. When most traders (myself included) have a large gap against them in this type of trade they obviously hope the stock attempts to fill the gap. There's nothing necessarily wrong with that as long as it doesn't get in the way of your exit strategy. Although I hoped RIMM would rally higher through the day, I didn't want to lose more money by having the bottom fall out of the stock. So I used the first 5 minute candles low as my trigger to exit. If throughout the day RIMM is able to stay above that low and move sideways or higher, I'm holding on to make some money back. If it breaks the low, I'm out (click image to enlarge).

[Source: EduTrader]

Using the 5 min. low turned out to be a pretty good exit, as once it was broken RIMM continued its selloff.

Thursday, September 24, 2009

Like last quarter's earnings, RIMM has a noteable pop in implied volatility going into its earnings announcement. As mentioned in the Volatility Crush post linked to yesterday, option premiums get bid up in anticipation of the earnings announcement causing a lift in implied volatility. As traders are purchasing calls or puts, they willingly bid up or pay more for these options as they *know* the stock will gap one way or another in reaction to the earnings announcement. Thus, they hope they will be compensated for paying up for these options by a large favorable gap in the underlying.

With 30 day HV currently at 26% and 10 day HV even lower at a measly 18%, recent realized volatility is rather low. IVolatility's Index Mean is at 56%, displaying an obvious premium and expectation of increased volatility in the underlying stock price going forward (click on image to enlarge).

[Source: IVolatility]

As mentioned in previous earnings plays, if you believe IV is too high then you'd be a seller of options. Conversely, if you think it's too cheap and we're actually going to see a larger move than is expected, then you'd be a buyer. Unless you want to take a directional bet, most traders looking to play volatility (long or short) will use a delta neutral play such as a strangle or iron condor.

OCT 75-95 StrangleWith RIMM currently trading around $84, one potential play would be to sell an OTM call and put. Let's take a look at selling the Oct 75 put and Oct 95 call for a combined credit of $3.30.

[Source: EduTrader]

As you can see the trade is profitable at expiration as long as RIMM stays between 71.70 and 98.30. If you're uncomfortable or don't have the trading permission to sell naked options, you could consider entering an iron condor instead.

Wednesday, September 23, 2009

In preparation for RIMM earnings after the bell tomorrow as well as the earnings season looming on the horizon, I wanted to review an options play on RIMM's earnings last quarter which captures the essence of gaming volatility into earnings. Like last earnings season, I'll probably post a few potential earnings plays this go around. The posts mentioned below will not only shed insight on RIMM's last announcement, but also give a nice snapshot of my approach when playing earnings.

Tuesday, September 22, 2009

Each expiration cycle I typically take a gander at VIX options in an effort to find potential plays. As I've mentioned previously, I like the higher probability inherent with selling puts (particularly on a mean reverting underlying such as the VIX) vs. making a speculative play by buying OTM calls.Before I jump into VIX options, let's take a brief moment to survey the current volatility landscape:

30 day historical volatility on the SPX sits at 16% - a level it's been parked at for about a month. Although it could certainly go lower, it seems to have found a suitable home for now.Cash VIX currently sits around 23.5. As you can see in the graphic below, the cash VIX has been reticent to probe below 23 over the last 2 months.October VIX futures are at 26.25.November VIX futures are at 28.

[Source: EduTrader]

OptionsXpress provides a great view of the various expiration months and strikes to choose from via its Put and Call Matrix. Take a look at the Puts Matrix below (click on image to enlarge):

[Source: OptionsXpress]

Interesting Observations:

The Oct 25 strike put is trading for more than the Nov 25 strike put. The difference is even more pronounced in the further ITM strikes (27.50, 30). On any other put matrix for normal equity options longer term options are always more expensive due to the fact that November has more time premium than October. So why do we have this interesting price structure with VIX options?

1. Mean Reversion- If option traders believe the VIX is currently too low and its mean is higher than current VIX prices, then it stands to reason that the VIX should revert back to higher prices over time. Thus, VIX option traders will use higher prices in pricing VIX options for longer dated months. If that weren't the case and 23.50 (current cash VIX) was used to price the options in all months, then it certainly would not make sense for October puts to be more expensive than November.

2. VIX Futures- In answering the question as to where traders believe the VIX will be at later dates, we can look to VIX futures. Indeed, the underlying for VIX options is not the cash VIX, currently at 23.50, but VIX futures. When you use the futures price, the pricing on VIX options makes a lot more sense. Consider the following:

Oct VIX Futures = 26.25, Oct VIX 25 put = $1.30

Nov VIX Futures = 28, Nov VIX 25 put = $1.20

Although the November put has one more month of time, the expected price of the VIX in november is 28, making the 25 strike put $3 OTM; whereas the October 25 strike put is only $1.25 OTM.For other related posts on the VIX, check these out:Gaming Time and Volatility

2. The 1x2 put spread is more sensitive to changes in volatility (negative vega). This should be intuitive since we sold twice as many options as we bought. If volatility decreased as the stock dropped in value, that would decrease the value of the short options more than the value of the long option. When options seem overpriced it's tempting to enter the 1x2 spread and sell more premium.

3. The 1x2 put spread can lose money if the stock drops too far; the regular put spread can't. This is due to the fact that the 1x2 put spread involves selling a naked put. Keep this in mind when choosing which stocks your going to play and which strikes you choose. The reason I was comfortable selling the extra naked put on BBY was because I thought the odds of BBY probing below $32.65 (my breakeven point) were negligible.

Now, why use the 37.50 and 35 strikes instead of the 40? At the time of the trade suggestion, BBY was trading around $40.

The primary reason one would use further OTM strikes (like 37.50 and 35) would be to lower the cost of the trade. The 40-37.50 1x2 spread was trading around $.80. The 37.50-35 spread was trading around $.20. It also shifts your profit zone. The former trades max profit comes around $37.50 the latter comes at $35.

In hindsight, the 40-37.50 spread would have worked a lot better. After earnings BBY settled right around $37.50 resulting in a tidy profit for that trade.

Thursday, September 17, 2009

The play was a bearish 1x2 put spread where we purchased 1 Sept 37.50 put and sold 2 Sept. 35 puts for a net debit around $.20. To realize the max profit we needed BBY to be at $35 by Friday's expiration. Take a look at the chart below to view BBY's reaction to earnings (click on image to enlarge).

[Source: EduTrader]

Prior to earnings BBY was trading around $40, making the Sept. OTM put options we used rather cheap. Although BBY sold off after earnings, it didn't sell off as much as I would have preferred. Right now BBY is trading around $37.70, making the Sept. 35 puts worthless and the Sept. 37.50 puts trading around $.30. I decided today to close out the long 37.50 put for $.30 and let the 35 puts expire worthless tomorrow. With only one day left to expiration and the 37.50 puts currently OTM, it would be a gamble to hold them tomorrow and risk having BBY remaining above $37.50.

If you entered at a debit of $.20, you'd have a 50% profit. Although $.20 was the net debit used on Friday night, reality is you probably wouldn't have been filled unless you entered around .30 or .35 debit. That being the case, the trade was probably a wash (at least it was for me).

I don't tend to dabble with vertical ratio spreads too often, but based on the BBY trade I think it's fair to say that they provide a better alternative than buying puts or calls outright when making a directional bet going into earnings.

I must admit calculating settlement values for European Style Index Options always seemed kind of a mystery to me. I, along with most option traders, had always thought the settlement value should be identical (or very close to) the opening price. Well, today the VIX opened at 23.29. So most traders would assume that would be the settlement price.

Close... but no cigar.

There are two ways I know of to check for the settlement value. Either head over to the CBOE Index Settlement Value page or find out what the ticker symbol is for the Index settlement value and plug it into a charting platform. As mentioned above, the ticker for the VIX settlement is VRO (click image to enlarge).

[Source: EduTrader]

Tip: When viewing the settlement price, use a line chart not candlesticks.

As the chart displays (and CBOE confirms) the settlement price for Sept. VIX options was 23.64. So, not too far off of the actual opening price for the VIX (23.29), but different nonetheless. The line in the sand for the put plays talked about yesterday was 23.60. Given that we settled at 23.64, both trades would have pretty much been a wash. Technically selling the put would have made you $.04, so I guess it's fair to say that was the winner.

For those who want more information on settlement values and how they're calculated, the best explanation I've read was in The Rookie's Guide to Options by MarkWolfinger.

Tuesday, September 15, 2009

With VIX options expiration on the horizon, we've got some interesting 1 day potential plays for those with the gambling spirit. First off, those unfamiliar with VIX options would be wise to check out the CBOE VIX options specification page. Per the aforementioned page VIX options expiration is:

The Wednesday that is thirty days prior to the third Fridayof the calendar month immediately following the expiring month.

Talk about a mouthful... The majority of the time (8 out of the 12 months in 2009) VIX expiration falls on the Wednesday within the normal equity options expiration week. For the record, the other 4 expiration days occur on the Wednesday following equity options expiration week (at least in 2009). Check out an options expiration calendar to view the dates.

Currently the VIX cash sits around 23.80 with September VIX futures sitting right at 23.70. Remember, the VIX cash and the front month VIX futures converge at expiration. Thus, the settlement price for Sept. VIX futures and VIX options should be identical. Although there may be a wide disparity between the two prior to expiration, sometimes the futures trading at a premium, sometimes at a discount; as expiration approaches that disparity will incrementally diminish until they both settle at identical prices. Since there is currently only a .10 difference between the two, you can see the disparity has all but disappeared.

If we look at the current option chains via a put matrix (a trick I picked up from Bill over at VIXandMORE). The logical choice for which option to play into expiration is the Sep 25 put (the graphic didn't come in that clear, so click on it to enlarge).

[Source: OptionsXpress]

Even as a gamble, the Sep 22.50 is probably too far OTM to make it worthwhile, and the 27.50 is probably too far ITM. Currently the Sept. 25 puts are sitting around $1.40, a mere $.20 over parity. So, if I wanted to bet the VIX continues to drift lower (SPX continues sideways to bullish) for the remainder of the day and we get a lower settlement price tomorrow, I could buy the put outright. As long as the settlement price were $23.60 or lower, I would have a winner.

Conversely, if I thought it a better bet the VIX would ramp higher for the remainder of the day and we get a higher settlement price tomorrow, I could sell the put outright. As long as the settlement price was higher than $23.60, I would have a winner. Remember, the VIX options are European style and settled in cash, so even if the short put expired ITM you wouldn't have to worry about buying shares of the VIX. Indeed, it's not even possible to trade shares of the VIX as there aren't any available.

Monday, September 14, 2009

With Best Buy (BBY) earnings on the docket for Tuesday, the Options Action pundits took a stab at a couple earnings plays on the retail behemoth on Friday night. Given the strong run BBY has put in over the last few months, in addition to the questionable spending prowess of the current consumer, the over riding tone was bearish going into Tuesday's third quarter earnings announcement. Let's break down one of the strategies ; the 1 x 2 put spread.

Over the past 4 quarters BBY has moved an average of 10% after earnings. With BBY currently trading around $40, the front month (Sep) ATM straddle is trading for $3, implying about an 8% move between now and Friday. A quick look at the volatility chart shows implied vol has lifted a bit off of its 52 week lows into earnings, but probably not enough to get excited about (click image to enlarge).

[Source: IVolatility]

The PlayThe 1x2 put spread, is also referred to as a vertical ratio spread. Think of it as buying a put spread, with an additional short put. The recommendation was to buy a Sep 37.50 put and sell two Sep 35 puts for a net debit around $.20.

So what's the bet?

Like a normal 37.50-35 put spread, we want the stock to reside at or below $35. However, since we're short an additional 35 put option, we can potentially lose money if the stock drops too much. Based on the risk graph below, our profit zone resides between $37.35 and $32.65. So, although this is a bearish trade, if BBY drops more than 18% (below $32.65), it could turn into a loser. However, given that the current ATM straddle is implying a move of merely 8%, an 18% drop is certainly not likely (click on image to enlarge).

[Source: EduTrader]

Yet another way to think of the vertical ratio spread is the inverse of a ratio back spread. Those selling ratio backspreads (i.e. buying a vertical ratio spread- buy a higher strike put, sell multiple lower strike puts), will have a profit/loss graph that is the inverse of those buying the ratio bacskpread (sell a higher strike put, buy multiple lower strike puts). If you were to flip the risk graph above upside down it would look like a put ratio backspread. Take a look at the risk graph juxtaposed with the stock chart (click to enlarge).

[Source: EduTrader]

If BBY remains above $37.50, which would occur if there is a neutral to positive reaction to tomorrow's earnings, our risk is the net debit we paid at trade inception. Currently that's a measly $.20. Typically I don't like straight directional plays into earnings announcements, but this type of play is certainly tempting. The premium received from selling the additional 35 put aided in dropping the net debit paid, thereby reducing our upside risk.

Friday, September 11, 2009

We've finally reached the conclusion of our short, yet to some too long, expedition into the volatility arena. As I often provide commentary on HV, I thought it useful to offer an in depth overview of its different nuances. So with out further ado, here's part IV.

After understanding the basic definitions and nuances of how historical volatility is calculated, most traders naturally wonder how to determine whether it is high or low. The first thing to recognize is there are no absolute levels that are considered “high” or “low” for HV. Each individual index or stock exhibits varying levels of HV. High HV for Wal-Mart (WMT) may very well be low HV for Apple Inc. (AAPL). The most common method for determining whether HV is high or low is comparing current HV levels to a historical range of HV levels. For example, over the last year the 30 day HV of AAPL has ranged between 23% and 107%. Because the current level of 30 day HV resides at 26%, it is fair to say that it is low (click to enlarge).

[Source: EduTrader]

Wal-Mart, a considerably less volatile stock, has seen its 30 day HV range between 64% and 11%. Like Apple, Wal-Mart’s 30 day HV currently resides at the lower end of its yearly range. Thus, it’s also fair to say that WMT HV is currently low (click to enlarge).

[Source: EduTrader]

The primary reason WMT and AAPL are being used as examples is because they come from two completely different sectors. AAPL resides in the technology sector which historically is a more aggressive, volatile space to trade in. WMT, on the other hand, resides in the consumer staples sector which is historically a more defensive, less volatile space to trade in.

Now that you've ingested a healthy does of HV theory, let's get specific on the application piece of the puzzle. For stock trading, a simple (and hopefully obvious) approach is to use HV as a measure of risk. Because stocks with higher levels of HV are undoubtedly more volatile, they require a higher risk tolerance. If you’re risk averse and abhor trading volatile stocks then steer clear of those that possess higher HV. As you’re building your watch list of stocks you’d like to trade, it may be prudent to assess HV and make sure it's within your comfort zone.

In addition to using HV as a gauge of risk, option traders typically utilize HV to help in gauging whether or not options are cheap or expensive. In subsequent articles we'll elaborate on this method...

Thursday, September 10, 2009

In theory historical volatility is blind to the trend of the stock, thus it shouldn't be used to predict stock direction. For example, suppose HV is high and you think it will begin to come back down to its average. Does that have any influence on your outlook on the stock? In other words, if you think HV is going to drop, does that mean the stock price will drop also? If you subscribe to the notion that volatility is blind to trend, then the answer is no. Remember HV measures price movement, not price direction. HV can be moving down whether the stock price is rising or falling. Conversely, HV can be moving up whether the stock price is rising or falling. Although theory states that there is not necessarily a direct correlation between HV and price direction, in the real world there usually is a distinct relationship between HV and price direction.

You have all probably heard that stock prices tend to fall faster than they rise. To give credence to this claim let’s review the last 10 years of the S&P 500 Index which encompasses two bull markets and two bear markets. When the S&P originally rose from 800 to 1500 it took approximately 3 years and 1 month (February 1997 to March 2000). During the ensuing bear market it took a mere 2 years and 4 months to fall from 1500 back down to 800 (March 2000 to July 2002). A comparison of these two time frames shows the market fell about 32% faster than it rose. From the July 2002 lows of 800, it took the S&P about 5 years and 3 months (July 2002 to October 2007) to rise once again back to 1500. As you are all aware, the market has taken quite a tumble since the October 2007 highs. Incredibly the S&P dropped from 1500 back down to 800 in a mere 1 year and 1 month (October 2007 to November 2008). A comparison of these two time frames show the market fell about 384% faster than it rose. There are certainly exceptions to the rule (gold and the VIX come to mind), but it is indisputable that over the last decade stocks have fallen quicker than they’ve risen.

[Source: EduTrader]

If you accept this notion then you also must concede that stocks tend to exhibit more volatility when they fall than when they rise. In other words, there tends to be an inverse relationship between HV and price. For example, look at the following picture and focus on the relationship between HV and the stock price. Take note of the grey arrows which illustrate HV’s tendency to increase as the S&P 500 falls in price and decrease as the S&P 500 rises in price.

Wednesday, September 9, 2009

Historical volatility can be measured over any time frame you desire. Commonly used time periods include 10, 30, and 90 days. If you want to view different lengths simultaneously, some software programs allow you the ability to overlay them on top of each other which aids in making comparisons. Take a look at a chart of the S&P 500 index which compares historical vol over three different time frames (click to enlarge).

[Source: EduTrader]

Here are a few important nuances with the different time periods:

1. Much like moving averages, short measurements of HV such as 10 days move quicker and are more erratic or noisy. The advantage to using a shorter term level of HV is it can provide a quicker indication as to whether or not volatility is picking up or dropping, but it gives more false signals due to its erratic nature.2. Longer measurements of HV such as 30 or 90 days are slower moving and less erratic. As such they provide slower indications as to whether or not volatility is picking up or dropping.3. When you get an extended expansion or compression in volatility (i.e. the stock continues to increase or decrease in volatility), shorter term levels of HV tend to lead the longer term levels of HV. This should come as no surprise as we’ve already asserted that shorter term HV moves quicker than longer term HV.

Assessing a longer term view of any length of historical volatility (10,30,90, etc...) causes one to see that it is mean reverting. Whereas a stock could trend up indefinitely, HV typically oscillates in a range around its average. For example, between 2004 and 2007, 30 day HV on the S&P 500 Index oscillated around 11, moving as high as 16 and as low as 6 (click to enlarge).

[Source: EduTrader]

We can reasonably expect that when HV gets too high or too low it will at some point return to its average. Unfortunately the “average” level perpetually changes, which means that just because 11 was the average between 2004 and 2007 doesn’t mean it will always be the average. As market conditions change, the norm for historical volatility will undoubtedly change also. For example, in the first chart, you can see current 30 day HV on the S&P is at 16. Compared to 2004-2007 that seems high, but compared to the last 6 months it actually seems quite low. Due to the bear market we’ve experienced volatility levels have been quite elevated through 2008 and 2009.

Tuesday, September 8, 2009

When most traders hear the word volatility, they typically think of how much a stock fluctuates in price. An oft used analogy in many financial cartoons is that of a roller coaster. What does a roller coaster help portray? Well it certainly causes one to think of the fast movements and large ups and downs. Volatility in this context could refer to the speed at which a stock moves or the magnitude of its swings. We call this type of volatility "historical volatility" or HV for short. In some texts historical volatility is referred to as statistical or realized volatility. All three terms usually refer to the same thing, so don't fret if they're sometimes used interchangeably.

The first thing to emphasize is that HV is derived from the stock price. Another frequently used measure of volatility, called implied volatility, is derived from option prices. This distinction is important so commit it to memory! Let's focus on the 'historical' part of historical volatility. HV can be thought of as a rear view mirror in that it looks backwards at a stocks history to derive its value. More specifically, as defined by Investopedia,

So let's assume that we're comparing the HV of two $50 stocks, ABC and XYZ, for the last 30 days.

Using the above definition, suppose ABC had an average price of $45 over the last 30 days. Furthermore, in that time frame it rose as high as $60 and as low as $30. XYZ also had an average price of $45 over the last 30 days, but only rose as high as $53 and as low as $40.Which stock would you has has a higher HV? Did you guess XYZ? If yes, then re-read the prior paragraphs! If you guessed ABC, then congratulations keep reading. The answer is ABC because it deviated much more from its average price than XYZ.

Remember, stocks with low HV tend to move less, while stocks with high HV move more.

Thursday, September 3, 2009

Yesterday's post explored two methods for lowering one's delta exposure on a long AAPL stock position. If you missed it, scroll down and read it first.

Today let's tackle shorting calls, the third potential negative delta trade. Although there are a myriad of calls available to short, the conventional approach for selling covered calls is usually to sell a short term, out-of-the money call option. Let's see the affect that has on our position delta, then we'll highlight an alternative.

Over-Write #1With AAPL currently around $166, the Sept. 170 call would be the front month, first strike out of the money.

With my new position I've succeeded in cutting down my delta exposure. If AAPL were to drop $1, instead of losing $100 (as I would have with the original position), I merely lose $61. Now, at the same rate I also don't make as much money if AAPL continues to rise. That is the opportunity cost of hedging the position. You forfeit some upside to hedge off part of your risk.

It's also worth pointing out that unlike the protective put highlighted yesterday, a covered call is a negative gamma trade- meaning my net delta will actually begin to increase if the stock falls (my losses will accelerate) and it will decrease as the stock rises (my gains will decelerate).

Why?

Because my long stock position has a fixed delta of +100, but the short call option has a variable delta. Although the call is currently showing a -39 delta, its delta will get smaller and smaller as the stock falls, as well as larger as the stock rises. The "negative gamma" aspect of the trade causes the covered call position to experience accelerating losses as the stock falls, and decelerating gains as the stock rises. I've provided a visual to help drive the point home. Take note of the slope of the blue line in the risk graph below.

[Source: EduTrader]

Suppose I want to lower my net delta by more than 39 deltas. Could I find a call option to short that has a higher delta, thereby providing more hedge? Certainly. Let's take a look at selling a Sept. 160 call.

So what's the primary diff between both examples? Well look at the difference in net delta. By selling an in the money call with a higher delta, I was able to hedge my position delta to a greater degree than selling an out of the money call option (+25 vs. +61).

Another important distinction between using long puts vs. short calls to hedge is that while the former increase in effectiveness as the stock price drops, the latter actually lose there effectiveness.

Keep in mind the delta perspective when choosing strikes for covered calls.

Wednesday, September 2, 2009

After my covered call post, I find myself somewhat uninspired to delve into other subject matter. It seems my creative flame has been snuffed out for the time being. So, let's expound on the benefits of the covered call. Rather than taking the conventional route and pontificating on the well known advantages to covered call writing, namely monthly income and downside protection; I'm going to view things primarily from a delta perspective.

Suppose we were savvy enough to purchase 100 shares of AAPL back in April around $120 when the overall market was in the beginning stages of what we now know as one of the strongest bear market rallies to date. With AAPL currently residing at $165, we're currently the proud owners of a $4500 unrealized gain. A tidy sum to be sure...

Given that we're long 100 shares, our current position delta on AAPL is +100. On the bright side, as AAPL continues to rise, we're making $100 per $1 move. On the other hand, if AAPL were to fall in value we would give back $100 per $1 drop. After accumulating a pretty stellar gain in AAPL, rather than letting our hubris get the best of us, it would be prudent to hedge our position to minimize the bleeding that will occur if the bottom falls out of AAPL. In short, we need to lower our delta exposure.

From days back in my post on delta, I showed the following table illustrating the six core actions traders could make, categorized by delta:

Positive Delta (Bullish): Long Stock, Long Calls, Short Puts

Negative Delta (Bearish): Short Stock, Long Puts, Short Calls

If I possess a bullish position (like our AAPL long stock) and desire to lower my delta position, I can do so by entering an opposing negative delta trades. Let's take a look at all three choices...

Short Stock:

The first and simplest approach would be to sell part of my position. For example I could sell 1/2 of my position or 50 shares.

Original position: Long 100 shares Delta +100

Adjustment: Sell 50 shares Delta -50

New Position: Long 50 shares Delta +50

With my new position, I've cut my delta exposure in half so that if AAPL drops, I now only lose $50 per $1 drop in the stock.

Long Put:

How's about just buying a put option to protect part of my gains.

Original Position: Long 100 shares Delta +100

Adjustment: Buy 1 October 165 put for $7.50 Delta = -45

New Position: Long 100 shares and Oct 165 put Delta = +55

With my new position I've certainly cut down my delta exposure. In addition, by buying a put I'm now in a positive gamma trade, so my net delta will continue to decrease if the stock falls (my losses will decelerate) and my net delta will increase back towards +100 as the stock rises.

Disclaimer

All content on this site is provided for informational and educational purposes. Furthermore, information contained herein reflects the opinions of its author and is provided for discussion purposes only. Under no circumstances does this information represent a recommendation to buy or sell securities, nor should it be construed as investment advice. Although the material is deemed to be accurate and reliable, I don't make any representations as to its accuracy, as a result there is no guarantee it is not without errors. I may or may not have positions in some of the names I mention.